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Winter is here… and why this is a great time to invest

Neeraj Bhargava

Neeraj Bhargava

The digital/tech area is in the midst of a much-expected correction in valuations and expectations. Evidence is mounting in the US for sure that the correction is clearly underway:

  • Mark-downs of Snapchat and Dropbox by Fidelity and BlackRock, respectively
  • Lower-than-private-round pricing of Square IPO
  • Failure of Deezer IPO

We will see more of these across the world and, to use a fashionable term, ‘stray incidents’ like lay-offs at Tiny Owl and Housing and low revenue memo of Zomato CEO are just a few examples of what is transpiring in several digital players in India as well. Since it is just past Diwali and for many of us it is all about reflecting and looking at the times ahead, here is how I see things unfolding in India.

The winter will be dark and painful

There will be more down-rounds (often 25 per cent to 50 per cent lower), consolidations, lay-offs and closures – this movie has been seen before in other ‘winters’ (e.g. 1999-2001 and 2007-09) and we will see it again.

Funding will get very difficult and more concentrated around a few market leaders and even they will struggle to justify previous valuations and multiples.

C&E (Cash and EBITDA) will be talked about more than R&B (Raise and Burn) in board rooms.

GMV (should have been called GMR, or Gross Misrepresentation of Reality) as a metric will be stripped of taxes, discounts, returns, currency changes, all other adjustments to get the real picture. Even after that unit economics and C&E will be the metrics investors will really assess.

Our Unicorns ≠ UniBucks (at least for a while)

Total segment domination and the ability to set prices is the only defence against the R&B vicious circle. Unfortunately, even the Unicorns in India do not enjoy that luxury.

The horizontal e-commerce Unicorns in India – Flipkart, Snapdeal, Amazon, and adding ShopClues and even a more diversified Paytm – are in a dogfight with no end in sight. They have to discount to grow because if they don’t grow they lose the right to justify their multiples. But if they continue discounting, then C&E becomes an issue. So they have to keep riding the tiger and continue R&B – there hasn’t seen a-rock-and-a-hard-place trap as bad as this before and it doesn’t help that Amazon keeps on growing from strength to strength and getting more aggressive.

The online classified players have even bigger issues. Unlike the e-commerce Unicorns, Quikr, OLX, the real estate and car classified firms and other listing-related ones like Zomato have yet to see a serious revenue jump that matches their astounding valuation surge. They all have a serious dogfight coming with no one being particularly dominant in their segment (well Zomato is, but is revenue growth justifying valuation?). All the dogs in the fight will get hurt, and there will be a lot of yelping around as it will be painful. Can they really grow subscriptions and start getting serious cuts from transactions, and both at a reasonable customer acquisition cost? This is not clear as yet.

Ola and Uber? Ditto, serious dogfight with no end in sight.

Ad-tech? Tough for InMobi and Pubmatic to claim resilience and justify high valuations when Facebook and Google want to eat it all.

Payments? Paytm has an extraordinary franchise but is it too distracted with other possibilities? Does it make sense to grab more even before it is profitable? Don’t know, time will tell.

Probably the only secure privately-held Unicorn in India is MuSigma – no surprise there as it has real profits and real cash generation. All the rest of the Unicorns are work in process.

Too big to fail? Perhaps, but not after a lot of turmoil and possible down rounds. The road to the conversion of a Unicorn into UniBucks (my term for billion-dollar payoffs to investors) still appears long and arduous with no clear end in sight. For now I see only Uniburns, i.e. companies that burn billions and still not be clear how they exit and provide true cash returns to investors.

Aspiring Unicorns have to get back to basics

“The more things change the more they remain the same” – Jean-Baptiste Alphonse Karr, French critic and journalist, 1849

There are several Unicorn aspirants in vertical e-commerce (including ones in our portfolio) in segments such as grocery (BigBasket), furniture and home décor (PepperFry and Urban Ladder), apparel (YepMe and Zivame), babies (FirstCry), jewelry (CaratLane and BlueStone), eyewear (Lenskart), cosmetics (Purplle and Nykaa), and online healthcare (Practo). They will find it tougher to raise new capital if unit economics don’t add up and there is no clear path to being EBITDA positive. Their current R&B approach to doing business will need to be junked. In addition, in some segments, the horizontals will either invade their territory or buy these players. Also, some of these will not survive the carnage.

Hyper-local delivery companies appear to be getting to Uniburn status in a hurry and that too with terrible unit economics. It will take either the very brave or the very foolish to keep funding them.

Other segments such as online budget hotels, food delivery, cloud kitchens, on-demand services, MCNs/digital media, online healthcare, online insurance, online dating, B2B e-commerce, etc. will probably see one or two survivors and the rest will either be consolidated or obliterated.

Even SaaS companies will not be spared; numbers will have to add up or the lofty multiples will dry out.

Even the survivors will need to assume that funding will be harder to come by and multiples will shrink. So if one is getting money at a lower-than-expected valuation – take it! The winter could be long and hard (though my gut is that it will be one to two years and shorter than previous ones). Smarter Unicorn aspirants will assume that the money they have or can raise quickly is their last round and will build a great company within their means. Taking longer is okay.

Investors will (and I hope they do) get financially more rigorous and seek hard answers on the steady-state economics, i.e. when companies get EBITDA positive and make money. It is back to the basics and focusing on building a ‘real’ business.

For early-stage startups, good news and very bad news

The good news is that several Series A funds have lots of dry powder – Accel, Kalaari, Matrix, Nexus, SAIF, Sequoia, etc. will all continue to invest and there will be some fantastic opportunities as the extraordinary customer adoption, benefits of a hyper-connected world and improvements in broadband infrastructure will continue. This is a great time to invest, much like 2008-2011 when many Unicorns of today were created. Many investors have seen such down cycles before and they will not retreat. We also plan to continue investing at our regular rate of one to two deals per quarter.

However, Series A investors have to be prepared to fund fewer deals and fund the winners more as Series B/C will not be easy to come by as the ‘hedgies’ boosting up this market and valuations are more or less gone. Indian startups are not a good ‘trade’ anymore!

The really bad news is that funding will be available to only a small number of players, as investors get overly conservative. There will be mass closures or scale downs and heavy bleeding for many angel, seed and Series A investors. Capital will vanish for not only the vague and fluffy ideas but even for some good ones as they will get washed away with the tide and sink.

From my past experience, it will not be surprising that as the tide turns, resources and support for the digital sector also will move the other way. Talent acquisition will get tougher. The rather aggressive Indian media celebrating the startups will brutally analyze every piece of bad news and make life even more traumatic for the companies in peril. Also, support industries such as logistics, advertising, legal, and business advisory services will feel the pinch and pause on their digital segment growth initiatives.

Sunshine again and a great time to invest and build them right

Much of the down cycle is self-inflicted. We have done it to ourselves yet again, i.e. disrespected money and ignored the basics.

However, the case for disruption and leap-frogging in India continues to be strong. We do not have a market problem, the market growth couldn’t be better.  Problems lie with mindsets of entrepreneurs and investors (us included) in the view that growth is all that counts, that high valuation is our birthright irrespective of whether the numbers ever added up and that the R&B music will never stop.

What we will see now is that some existing players will fix things fast. Also, some new Minicorns (Unicorns in the making) will grow prudently and we will see some stellar successes in the form of exits and large mark-ups and quicker than we can imagine. The optimist in me also believes that this is a great time to invest as we could buy into some great companies at the right valuations and with a saner mindset to create value the old-fashioned way through growth coupled with margins.

My gut is that things will bounce back a lot faster too but not without pain in the short term, maybe for one to two years. Till then, we have little option but to brace ourselves as the ride will be more than bumpy.

Neeraj Bhargava is senior MD and CEO at Zodius Capital. He has lived through two business cycles, first as the co-founder and managing partner of eVentures India, a fund that backed the Unicorn, MakeMyTrip, but still went belly-up, and then as the co-founder and CEO of NYSE-listed WNS, where he built a Unicorn, took it public and survived the 2007-09 meltdown despite client bankruptcies, currency crashes and falling transaction volumes. He is still struggling to find the right balance between acute paranoia and unbridled optimism. The views in this piece are entirely his own and not necessarily reflect the views of his firm, investors, partners and portfolio companies.

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